Remember the Enron Scandal? Let us jog your memory…
Voted “America’s Most Innovative Company” for six consecutive years, Enron Corporation was one of the largest companies in the United States. In 2001, it became the biggest corporate bankruptcy to have ever hit the financial world.
At their peak, Enron was a much riskier company than their financial statement let on in 2001.
The primary culprit? Their significant use of leases under the old leasing regulations, ASC 840, which only required capital leases on their balance sheet.
Over the course of the bankruptcy, shareholders lost over $11 billion. Their accounting firm was completely dissolved for off-the-book accounting, and the SEC (Security & Exchange Commission) sought improvements for lease disclosures overall. Talk about destructive.
This scandal is only one example of why changes had to be made to ASC 840, the previous lease accounting standard, and why a new lease standard has been introduced.
ASC 842, the new lease standard, is now officially in effect and has four important changes that every small business owner needs to know about.
- Reporting on operating leases has shifted.
ASC 840 classified leases in two ways: capital leases and operating leases. Capital leases were capitalized on the balance sheet and reported on the income statement, while operating leases were just reported in the footnotes of the financial statement.
This was a giant loophole.
Why? Although leases are similar to loans, companies have been able to exclude most leases from their financial statements. One of the reasons Enron collapsed so quickly was because of several thousand off-balance sheet liabilities—a whopping $40 billion in debt.
Simply put, they were able to make their books look way better than they actually were.
After the Enron scandal, the SEC decided that this particular method of reporting operating leases gave a very false view of the financial standing of companies, particularly to small investors.
With the new lease standard, we still use two groups: operating leases and finance leases. Except now, all companies with a lease of more than 12 months in length must report it on the balance sheet.
No if’s, and’s, or but’s.
- There may be added costs.
While there may be added costs to your lease agreement, it isn’t necessarily in the way you might think.
The new lease standard introduced the concept of lease and non-lease components. For instance, let’s say you decided to lease a large gym space. Within your contract you are probably paying for the gym itself (lease component), and also for the maintenance required to clean and upkeep that gym (non-lease component).
Before, these executory costs like taxes, maintenance fees, and insurance weren’t included in any of the lease calculations. Now considered “non-lease” components, these extra expenses are roped into your final numbers.
So, it may seem like there’s some extra costs, but really, this works to your advantage as you’re made aware from the get-go of any additional fees you’ll be inheriting with your lease.
- There are new criteria for lease classification.
For starters, this classification will now happen at the end of your lease term, rather than before you sign the papers.
With ASC 840, there were four main tests used in determining what lease to use:
- Transfer of ownership
- Option of a bargain purchase
- A lease term greater than or equal to 75% of the asset’s lifespan
- Current value of the minimum lease payment greater than or equal to 90% of the fair value of the leased property
These criteria remain mostly intact with the new lease standard, with the exception that the harsh lines surrounding the 75% and 90% have been blurred.
A fifth test has been added, however. This test focuses primarily on specialized leases.
This test essentially states that if the asset has no alternative use to the lessor at the end of the term, the lease must fall under a finance lease. What does this mean for you? Pay attention to the specifics, so you know what you’re getting into.
- Discount rates have changed.
When you’re bringing your present value onto your balance sheet, you will need to know your discount rate.
Under both the old and the new lease standards, business owners would generally use the incremental borrowing rate (IBR). However, this term is defined differently in both standards.
In the new lease standard, the IBR is referred to as “the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term, an amount equal to the lease payments in a similar economic environment.” OOF! That is a lot of verbiage, let’s break it down.
This essentially means that this rate relates to the rate your company would be charged to borrow. Compared to before, your company may have to put a bit more effort into identifying the correct discount rate to record on your lease. And yes, you’re responsible for the calculations.
Pro Tip: You can figure out your borrowing rate based on the currency, economic environment, and term of the loan. Work with the treasury team to help you calculate the IBR, since they will have the existing rates.
The new lease standard may require some studying but will ultimately protect you!
With ASC 842 in full effect, compliance is more complicated and demands a much higher level of effort across the board. From finding leases, to understanding the closing processes around them, you may want to put your student hat back on.
Now that all small businesses should’ve adopted this new standard for leasing, you have the upper hand and know what to look out for.
KYN Accounting knows the fine print, and wants to make it easy for you to navigate the financial world of your small business. Schedule a consultation today.
Having a hard time understanding what this means for you personally? Drop your questions in the comments below!